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Minyan Mailbag

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Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.

Professor Succo:

Could you comment about PIPEs (a.k.a. toxic financing) for cash-strapped companies?

Thanks.

Minyan Ron Sen, MD

PIPEs (Private Investment in Public Equity) come in two basic forms: convertible bonds with warrants attached and discount stock with warrants attached.

As Ron points out, public companies (I use the term loosely because many of these companies should not even be public) that have difficulty obtaining financing use the PIPEs format to raise money. They often don't even qualify for a bank loan, so they have to be creative and willing to dilute the company substantially in order to obtain additional funding.

It used to be that companies like this used a special type of convertible bond called a "reset" that could be "toxic" for the company if the stock price began going down. If the stock price dropped a certain percentage, the convertible bond holder had the right to call for more stock; this effectively lowered the strike price on the imbedded call option. The convertible bond holder would then sell more stock against the position to "hedge" the new strike. This process in effect protected the holder from declining asset values, but also could cause a "spiraling" down of the stock price. There were several cases where these types of deals drove the stocks, and then the companies, into the ground.

These resets were common a few years ago, but because of lawsuits by the companies who experienced these "spirals" they have become nearly extinct. The companies claimed they didn't know what they were getting into and the convertible bond holders who bought them (predominately hedge funds) claimed that they should have and were merely acting to protect their positions. Both sides were being disingenuous, but what else is new?

Now what is being used are straight convertible bond deals priced attractively or straight equity that comes at a significant discount. The deals normally have additional "free" warrants attached as an additional incentive: these deals are high risk, high reward.

We participate in some PIPEs deals now, but on a very selective and small basis. We must take a fundamental position in the company, something that we don't do lightly or often. We size them very small relative to our capital base and treat them as cheap call options. We normally only short the stock after an extended period of time and at much higher prices. Less than 30% work out, but when they do they more than make up for the ones that don't.

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No positions in stocks mentioned.

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